Climate change is real. The well documented increase in global temperature levels, the link with greenhouse gases and the again well documented rise in atmospheric CO2 levels (the main greenhouse gas) should, for all practical purposes, no longer leave any room for doubt. The vast majority of earth scientists and engineers working for oil companies do not doubt and have not done so for a long time. What has changed is the perception. From one of many problems that the world faced in the 1980’s (famine, nuclear weapons, overpopulation, “waldsterben”) this one struck us a difficult problem but one that was far away, for our children and technological progress to solve. These days we have seen that the last decade was the warmest decade on earth recorded so far. The decade before that was the second warmest. It has started to affect our lives in earnest.
The major oil companies accept that climate change is real. Furthermore they do not close their eyes for technological breakthroughs such as the dramatic decrease in price for solar panels (hopefully followed by a similar development in energy storage). If oil companies have been reluctant to invest in solar power or wind power it is not that they underestimate these technologies, but rather that they feel that solar panel fabrication is not something that can become sufficiently profitable for them or that they do not want to be dependent on subsidies. Image is important if one is to be dependent on subsidies. Oil companies are not popular; something that is unlikely to change.
The major oil companies see their strength in finding, producing and refining hydrocarbons. They expect that oil and gas demand is there to stay for several tens of years. They accept that the oil and gas industry will eventually become a sunset industry (later rather than sooner, but still). They would welcome a functioning carbon tax system. In their view it would reduce uncertainties and create a more level playing field (more so than for a system of unpredictable government subsidies and other measures to promote renewables) from which gas, the cleanest fossil fuel, could profit.
Implications for oil demand and price
Population and economic growth will add to oil demand. Increasing efficiencies, higher taxes or carbon pricing and the rise of renewables will reduce demand. How exactly this will pan out over the coming decades is highly uncertain (a key uncertainty being how quickly electric vehicles will gain market share). Statoil’s recent update of their long term scenario planning exhibits a large range for 2040 oil demand from 80 to 115 mbpd (million barrels per day). For comparison: current oil demand is just over 95 mbpd. The lower end member comes from their Renewal scenario that results in CO2 emissions in line with the target to limit global warming to two degrees Celsius. This scenario requires that the recent non-binding COP21 targets are not only met but are significantly exceeded. The higher end member comes from their Rivalry scenario where a lack of thrust and coordination result in a world where security of supply and economic growth for individual countries play a bigger role, at the expense of global climate concerns. Scenarios from other companies and organisations exhibit a similar large range for future oil demand.
Even the optimistic Renewal scenario implies that significant investments are still needed to meet a 80 mbpd oil demand in 2040. Oil field decline implies that without any activity a fields production drops on average by 8-9 % per year. Thus the oft quoted red queen analogon (“one has to keep running in order to stay in the same place” from Lewis Carroll’s Through the looking glass, and what Alice found there) remains valid. The difference between Rivalry and Renewal is that for Rivalry the oil industry needs to keep running a little faster, for Renewal it can run a little slower.
The oil industry can, and will, react to changes in demand and price in a matter of years (as we are currently seeing). It is in their best interest to do so (and they have a track record of doing so – if anything of over reacting). The energy transition on the other hand will be a matter of tens of years. I would thus argue that the energy transition is likely to result in a long term reduction in volumes but not to a reduction in price (at least not beyond the usual commodity boom and bust cycles). With relatively small changes in volumes and large swings in price it is the oil price that has by far the largest influence on oil companies’ profits.
Stranded assets and carbon bubbles
NGO’s like Carbon Tracker have made significant inroads with a theory that appeals through its simplicity. Starting with the emissions associated with a two degrees global warming limit one can derive the fossil fuel reserves (“carbon budget”) that can be burnt under such a constraint. Comparing these with the reserves of fossil fuel companies shows that a significant part of their reserves can not be burnt (“stranded assets”). With fossil fuel companies’ valuations based on these reserves this implies that their shares must be overvalued (“carbon bubble”).
Lumping all fossil fuels together, regardless of their economic value and associated emissions, is a severe simplication. I would certainly hope that the carbon budget of oil (a premium fossil fuel whose high energy density makes for instance flying possible) or gas (a relatively clean fossil fuel) can be increased at the expense of that of coal.
But the main issue I have with this theory is of a different nature: it lumps together all different types of reserves (proved, probable, possible; developed, undeveloped). In reality the value of a barrel of possible reserves, in an area where exploration may or may not prove the existence of oil, that may or may not be commercially developed, is only a tiny fraction of the value of a barrel of proved reserves that has already been developed (with significant investments for development already made). It are these low value possible reserves that run a risk of being stranded, rather than the high value proved reserves.
Proved reserves typically only account for 15 – 30 % of the total resource base of an oil company and account for 80 – 90 % of the value of a company (a detailed overview can be found in a recent IHS report). That is not surprising, given that proved reserves are either developed or in the process of being developed (for most companies project sanction is a prerequisite in order to book proved reserves). These are the assets were large investments have taken place or are currently taking place. In general, the investments related to developing a field are much larger (1 or 2 orders of magnitude) than the finding costs.
With typical proved reserves over production ratios of the order of 10 – 15 the risk that proved / developed oil reserves will turn out to be stranded is very small. Production from these assets falls far short of demand, even for a scenario which limits global warming to two degrees.
It are not the oil companies’ producing assets that are at risk but the long term continuation of their business model. But this is something that has been seen to be at risk for a long time already, be it for a different reason: the difficulties that oil companies have to replace reserves (even when spending vast amounts of money). Hence the relatively low price earning ratios of oil companies; typically of the order of 8 – 12 before the 2014 oil price drop.
A strong case can be made for carbon budgets and stranded assets in general. But those oil assets that may turn out to be stranded have been attributed a very small value. Hence I can not see a case for a bubble in the valuation of oil companies on the basis of stranded assets due to climate concerns.
All the world’s a stage and each much play a part
NGO’s like Carbon Tracker, in the words of Dieter Helm, tend to muddle up the public and the private domain. There may be a strong case for not investing in fossil fuel companies but I feel it is a case that should be based on ethical grounds rather than financial grounds (as has been done for the weapons and cigarette industries).
Aiming to reduce oil-related CO2 emissions by limiting investment in the oil industry might actually be counter-productive. Before we know it we could again enter a period of relatively high oil prices. I would much rather see high consumer oil prices due to a significant carbon tax (and using revenues for more meaningfull purposes in the OECD realm, including promoting renewables) than due to high oil prices at source level (resulting in increased revenues for Middle East producers).
NGO’s function as a lobby for renewables as well (be it a lobby that, unlike the fossil fuel lobby, has the aura of sainthood). They may well prefer direct subsidies for renewables to a carbon tax (replacing coal by gas being a very cost efficient way to reduce emissions in the short term). It is up to governments to find the right balance between a carbon tax to reduce emissions in the short term and direct subsidies to research and renewables to promote the technologies we need for a long term solution.
Oil companies have an obligation to their shareholders to maximise profits – within the limits of the law and a companies code of conduct. They are under no obligation to invest profits from oil into renewables or otherwise to contribute to solving matters that are of a public concern. It is up to governments to set the boundary conditions for the oil industry and to tax the use of fossil fuels (whether to generate revenue in general or for the promotion of renewables, to alleviate the adverse effects of fossil fuels or to discourage their use).
I feel that, from a financial point of view, oil companies will be better of by sticking to their core business and by accepting that they are likely to be in a sunset industry – in the long term. Whilst some of their assets may be stranded I cannot see the case for a carbon bubble based on stranded assets.
Black swans for the oil industry may exist but I feel they are of a very different nature. Should low cost Middle East producers change their oil policy and start to maximise volumes rather than revenue (whether due to political issues such as Saudi Arabia vs Iran tension or due to a perception that “the end of oil is near”) then this could result in oil prices being lower for longer for real. Should western governments or jurisdictions decide that oil companies should pay for the adverse climate effects of the past use of fossil fuels (something they happily allowed at the time) then this could have severe effects on oil companies profits. But let us not fool ourselves: the adverse effects of the use of fossil fuels on climate have been abundantly clear for many tens of years to governments, research institutes and companies alike. The readyness of many to demonise oil producers, whilst readily giving absolution to oil consumers, is striking.